Why Chinese Banks Are Especially Vulnerable To Higher Funding Costs

Those of us who think it’s important to track developments in China’s economy and financial system had our work cut out for us this week.

Beijing’s efforts to curb capital flight created a truly epic squeeze in offshore money markets. HIBOR hit record highs in at least one tenor, the overnight depo rate soared, and CNH forward points surged above 250. Before giving back some of its gains on Friday, the offshore yuan put up its largest weekly advance ever.

Onshore rates have been rising as well as the PBoC moves to contain leverage and curb speculation. Have a look:

(Charts: Deutsche Bank)

As discussed previously, the central bank is effectively reducing the spread speculators can earn by arbitraging the cost of short-term wholesale funding and the yield on funded assets. Have a look at the profile of Chinese banks’ liabilities:

(Chart: Deutsche Bank)

Note the growing reliance on wholesale funding. Now consider the following from Deutsche Bank:

Funding in China’s banking system has weakened in recent years, becoming increasingly reliant on wholesale funding, i.e., borrowing from banks, NBFIs, the bond market and the PBOC, which tend to be less stable and bear higher funding costs than deposits.

To contain risks, PBOC has lengthened the duration of liquidity injection and increased direct lending to smaller banks. This has pushed up interbank rates and increased the funding costs for speculators in the bond and shadow banking markets. With a narrower spread (even negative ones in some cases), these speculators were forced to delever in both markets. This is why we witnessed a notable bond market correction in December 2016.

And while this may be a long-term positive in terms of containing systemic risk, it’s a short-term negative as it squeezes leverage out of the bond market.

The problem: as speculators delever, the market loses what previously was a perpetual bid. That could well trigger another rout which would only serve to perpetuate a rather harrowing circular dynamic.

As I I’m fond of saying, they’re trying to delever and relever at the same time. They need to keep just enough of the industrial SOEs in business to keep the smokestack, export-driven economy afloat until the services/consumption-led model can kick in, but they also need to get rid of the excess capacity those SOEs create so they’re not fueling the global deflationary impulse. With the currency, they need it weaker to keep the economy afloat (again, until they can ease out of the mercantilist religion) and ultimately they’ll probably float it, but in the meantime, they don’t want to accidentally trigger some kind of global catastrophe by sparking a massive capital exodus. Perhaps most importantly, they need to somehow achieve the unachievable without sparking social upheaval and/or some kind of massive backlash against the Party.

Writing about a subject is the best
way to educate yourself about it, and when I flick through past work I remember how much
they taught me, if no one else. Mainly they taught me that I didn’t know very much. But they
also taught me that most other people didn’t know much either. Thus, some key themes
which stand out include the illusory control of policy makers, the presumed knowledge of
those looking to them to actively do good, the ease with which we fool ourselves, and how
best to protect capital in the face of such unavoidable uncertainty. -- Dylan Grice